Pump-and-dump scams may seem like a nostalgic anachronism from the 1980s and 1990s, perpetrated by schemers in skinny ties and pinstriped suits and profiled in Hollywood movies "The Wolf of Wall Street" and "Boiler Room." Yet illegal price manipulation has proven to be surprisingly persistent in penny stocks and microcap securities – and recent reports of similar frauds in cryptocurrency markets has brought renewed relevance to the subject.
The Old Model: Penny Stock and Microcap Fraud
Microcap and penny stocks are corporate securities issued by the smallest of companies with shares typically priced under two dollars. These stocks are thinly traded and have minimal regulatory disclosure requirements, making them susceptible to price manipulation.
In a pump-and-dump investment fraud scheme, unscrupulous promoters “pump” the stock of a nonperforming company by making sales pitches to private investors with false and misleading statements about potential returns.
These pitches often begin by unsolicited emails, cold calls, or posts in online investment forums by sources claiming to have inside information.
While the stock is being promoted, insiders secretly sell (i.e., “dump”) their own shares into the market and – depending on the size and scale of the operation – may reap millions in illicit proceeds.
The music stops as soon as the fraudsters cash out and walk away. The promotion ends, the stock price plummets, and outside investors lose everything.
The New Market: Cryptocurrency and Alt Coins
Today a similar cycle occurs in cryptocurrency markets. Although cryptocurrencies may seem like an innovative platform for investment fraud, these pump-and-dump schemes are based the same well-established price manipulation tactics that have been used for decades in the penny stock market.
In an initial coin offering (ICO), digital coins are issued in exchange for real money. There are now more than 1,200 cryptocurrencies and "alt coins" traded on electronic exchanges. ICOs were used to raise an estimated $3 billion in crowd-sourced investments in 2017, according to published estimates.
ICOs have emerged as a popular mechanism for startups to raise early-stage funding, but they can also be used to generate funds for any kind of venture. As one 25-year-old who runs a cryptocurrency hedge fund recently explained to The New York Times: “You can I.C.O. anything.”
Bitcoin, the best-known cryptocurrency, increased in value from $830 to $19,300 in 2017, a price surge driven by increased interest from speculators. Speculative markets in a sustained upswing attract enthusiastic new investors eager to join the latest financial craze. Yet as more investors have discovered, ICOs can also be used to fund fraud.
In some cases artificial demand is created by fraudsters who collude with others to buy shares of a specific alt coin, while agreeing to sell at a predetermined date. In the interim, the price of the currency rises and it becomes more attractive to outside speculators. As one anonymous trader told Business Insider: "There are groups on the deep web where they would say 'Buy that thing and hold until that date, and dump everything on that date and buy again 2 days later when price dropped,'" he said. "It looks much more 'natural' when it isn't at all."
From Boiler Rooms to Messaging Apps
Fraudulent offerings of penny stocks are often promoted to the public using call centers known as "boiler rooms" that engage in high-pressure sales tactics. Their unlicensed salespersons are paid high commissions for selling fraudulent stocks to unsuspecting victims. They rely on scripted pitches written with the intent to deceive investors and misrepresent potential profits.
In the 1990s, the North American Securities Administrators Association estimated that investors were losing $10 billion every year due to investment frauds promoted over the telephone. Today, the internet has partly – but not entirely – replaced telemarketing as the preferred technological channel for scammers to promote fraudulent securities.
The Securities and Exchange Commission (SEC) has filed enforcement actions against a number of multi-million-dollar boiler room operations in recent years, including several that targeted senior citizens. In 2017, the SEC filed charges of fraud and market manipulation against two operations in Long Island, NY, where victims were allegedly harassed and threatened by telemarketers. After one investor complained of financial losses, he was reportedly chastised by a salesperson who said: "I am tired of hearing from you. Do you have any rope at home? If so, tie a knot and hang yourself.” In a separate action in 2016, the SEC alleged a boiler room operation solicited $20 million from investors by misrepresenting the potential prospects of a pair of companies, including one memorably named "Fun Cool Free Inc." The SEC alleged that 90 percent of investor funds were misappropriated by the perpetrators of the scheme.
Fraudsters in cryptocurrency markets, on the other hand, frequently favor internet-based messaging apps, such as Telegram, to promote their scams, rather than relying on anything as old-fashioned as a telephone. Secure messaging apps and the native anonymity in these markets may make it more difficult – but not impossible – to identify the responsible parties.
Unlike a traditional boiler room where the promoters work shoulder-to-shoulder in the same office, market manipulators who collude online to pump cryptocurrencies often don't know the real identities of their co-conspirators, and have never met them in person, according to a source interviewed by Business Insider. He said: "We don't communicate on personal information. We don't even ask. It's like that. We are all in hacking and stuff for years and in these communities, we don't share personal info."
Lightly Regulated Markets
Microcap stocks are generally not listed on major exchanges like the New York Stock Exchange or NASDAQ. Instead, penny stocks are listed on interdealer quotation systems, OTC Markets Group and OTC Bulletin Board, featuring stock prices and trading options for more than 10,000 companies.
The OTC Bulletin Board (OTCBB) is administered by the Financial Industry Regulatory Authority (FINRA). OTCBB listed companies must remain current with requisite SEC filings, but are not subjected to other compliance requirements of major exchanges, such as minimum share price or corporate governance.
Competing systems with less rigorous compliance standards were established by the OTC Markets Group, a company that administers OTCQX, OTCQB, and Pink Sheets. These alternative systems are less transparent and have proven popular with companies seeking to protect the anonymity of their financials, insiders and operations. Companies quoted on these systems do not need to file with the SEC, but they may be required to satisfy requirements of OTC Markets Group. The OTCQX market, for example, requires companies to publish financial information and undergo a qualitative review. The OTCQB requires audited financials and a minimum bid increment of one penny ($0.01), in an effort to reduce dilutive stock schemes and related frauds. At murkiest end of the trading pool, Pink Sheets has no reporting requirements or financial standards whatsoever. OTC Markets Group acknowledges the companies quoted on Pink Sheets include "distressed, delinquent, and dark companies not willing or able to provide adequate information to investors."
Compared to the limited systems for OTC listings, virtual currency exchanges or digital currency exchanges (DCEs) offer a wide selection of competing - and potentially confusing - choices. These include better-known exchanges such as Coinbase and BTCChina as well as alternative services like Kraken, GDAX, Bittrex, Bitstamp, Binance, LocalBitcoins. They generally charge transaction-based fees or commissions, and have varying levels of compliance requirements for verifying the identity and legitimacy of market participants. DCEs can function alternately as market makers, commodity exchanges and money transmittal services.
Since 2013, digital currency exchanges have been subject to the Bank Secrecy Act (BSA) and must be registered as a Money Services Business (MSB), according to a guidance paper from the Financial Crimes Enforcement Network (FinCEN) of the U.S. Treasury. In many respects, government oversight is still emerging, although the Securities and Exchange Commission appears to be taking the lead on pursuing cryptocurrency-based securities fraud.
In December 2017, concerns of potential cryptocurrency market manipulation in combination with concerns of possible penny stock fraud prompted the SEC to suspend trading of shares in The Crypto Company, a publicly traded Nevada corporation with shares listed on the OTC Link alternative trading system.
OTC quotations systems are sometimes broadly referred to as “pink sheets” because the daily stock prices of penny stocks were once printed on pink paper. Today, the listing information is published electronically, but actual trading of penny stocks still occurs "over-the-counter" (OTC) through market-makers carrying an inventory of the securities. This is a considerably different model than a central exchange, like NYSE, where orders of listed securities are matched between buyers and sellers in an efficient, high-speed, electronic exchange. There is liquidity risk in OTC markets, and investors may find it difficult to find a buyer for poorly performing stocks.
Similar liquidity constraints are also seen in today's cryptocurrency markets, where alt coins with smaller circulation are potential prospects for price manipulation. Investors who arrive late to the party, after a pumped coin has been dumped, are left holding the currency as it falls in value, unable to find new buyers.
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